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The role of the shareholder

P E T E R M O N TA G N O N

Recent history – growing pressure on shareholders to act responsibly

It is generally recognised nowadays that Britain plays a pioneering role in corporate governance, but this focus and leadership is relatively new. It goes back to the Cadbury Code of 1992, which set out basic principles of board behaviour and how shareholders should respond. Cadbury has now undergone several mutations and evolved into the Combined Code. Through the code system, the UK has developed the famous comply-or-explain concept. This is the key to the UK approach to maintaining high standards of governance. Instead of prescriptive regulation, it relies on consensus around standards, followed by disclosure coupled with peer and shareholder pressure, to drive incremental change in behaviour. In recent years, the focus on the role of shareholders in pushing for high standards has grown significantly.

The UK’s lead in governance lies probably in the timing of its corporate scandals. The Cadbury Code was a response to the Maxwell and Polly Peck scandals of that period. The code system, introduced by the UK as a result, helped protect UK companies and their shareholders from the impact of subsequent excess at the height of the stock market bubble at the end of the 1990s. Of course, the market was not entirely free of shock: witness, the crises at Marconi and Cable & Wireless. Still, the UK did at that stage have some considered responses. Hence, for example, its approach to governance questions relating to audit was much less extreme than that of the US in the wake of Enron.

Yet the impact of the UK’s own model and the worldwide wave of scandals that followed the bursting of the bubble was to focus still more attention on shareholders and their role. Another factor – the election of a Labour Government in May 1997 – also played an important part. New Labour wanted to address excess in the behaviour of management, but it did not want to do so through the introduction of restrictive regulation or legislation. It felt that it was more appropriate to harness the power of the market and make institutional investors use their power of ownership to promote effective leadership at the top of companies. It therefore focused heavily on the operation of the investment chain with a series of reports by Paul Myners, Ron Sandler and Sir Derek Higgs.

In 2000, the problems encountered by Tomkins, a large conglomerate, reinforced the government’s argument. These were associated with a weak board structure, poor internal controls and financial excess. Legitimate questions were

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asked about why shareholders had done so little to intervene and address the issues before they became critical. Similarly, it was hard for institutional shareholders to escape some responsibility for the collapse of Marconi. Institutions had been actively urging the company to spend its cash on high-technology expansion to take account of the bubble in that sector. They had shown little concern to ensure that appropriate checks and balances accompanied the decision-making.

A particular public concern around this time was executive remuneration, which had been growing rapidly as the stock market bubble advanced. This was partly a reflection of the overall buoyancy of the market and partly a leaching across the Atlantic of the extraordinary excess in the US. For New Labour, remuneration was a particularly delicate issue. On the one hand, the very high rewards reaped by executives were offensive to traditional socialists. On the other, New Labour wanted to be business-friendly and not impose any formal pay policy for executives. Once again, putting the responsibility firmly in the hands of institutions was the obvious alternative. The public and press would blame shareholders if things got out of hand.

The political pressure became all the greater after the stock market bubble burst and public opinion became increasingly concerned about so-called ‘payment for failure’. The government’s eventual response was the Directors’ Remuneration Report Regulations of 2002. These require listed companies to produce an enhanced remuneration report on which shareholders are given an advisory vote. This was a substantial change. Not only was there to be more disclosure including a table showing relative performance but, for the first time, shareholders obtained a vote covering all aspects of remuneration. Previous voting had been confined to schemes involving the issue of shares to directors or dilutive share schemes, including those for the benefit of all employees.

Subsequently the government came under strong pressure from the Trades Union Congress and other left-wing supporters to take specific action to curb payment for failure. This is an extremely difficult area. Although there is universal agreement that executives who have caused a collapse in value should not walk away from their jobs with compensation, it is almost impossible to provide for such constraint in law. Not only is failure indefinable in legal terms, there was a clear risk that any legislation passed in Britain could be successfully challenged in the European courts. In the event the government backed away. It was helped in doing so by a guidance paper on the subject published by the Association of British Insurers and the National Association of Pension Funds and by recognition from the Confederation of British Industry of the need for voluntary action. All three organisations acknowledged that the key to addressing the problem lay in careful drafting of the service contract at the time the executive was hired. This has led to a change in practice. For example, contract lengths now rarely exceed one year.

Even though the government did not legislate to outlaw rewards for failure, it did undertake a series of measures to place additional responsibilities

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on shareholders. The Directors’ Remuneration Report Regulations, as noted above, introduced a vote on remuneration. The Myners Report on Institutional Investment in 2001 called for legislation to require institutions to take an activist stance along the lines of the US Erisa legislation on pension funds. The Higgs Report of 2002 was focused mainly on boards and their operation, but its proposals were generally seen as prescriptive and shareholders were to play an important role in policing them.

Finally, the Government introduced legislation in 2004 requiring companies to publish an Operating and Financial Review setting out the board’s view of material issues affecting its future, including environmental and social issues. Though this was designed to respond to pressure from environmental and other stakeholder groups, the thrust of the legislation was to place an onus on institutional investors to take these issues into account and engage with companies on them. The Operating and Financial Review was subsequently withdrawn because, in the view of the Treasury, the benefits were outweighed by the audit costs. However, companies will still be obliged under European law to produce a Business Review and the pressure on shareholders to become involved in consideration of all material issues affecting the company remains.

Overall, therefore, since the Cadbury Report there has been growing pressure, both market and political, on shareholders to take a more active interest in governance. This has been backed up with press comment. The media does now generally expect institutional shareholders to act as responsible owners. Indeed for many institutions, the willingness to do so has become a reputational issue in its own right.

Governance as an alternative to regulation

Where the contribution of shareholders creates an effective chain of accountability, governance can be harnessed to perform a role that otherwise requires regulation. In the US there is no prospect of companies being made effectively accountable to their owners, because shareholders lack the ultimate weapon of being able to dismiss boards. The result is that, when crisis strikes, the US has no option but to resort to more stringent regulation, regardless of the heavy compliance and administrative costs involved.

The UK’s code-based concept of comply-or-explain makes for a striking contrast. It enables companies to deviate from accepted norms of best practice provided they can persuade their shareholders that it is in their interest to do so. This is much less brittle than regulation and almost certainly better for value creation because of the different objectives of regulators and investors. While both wish to avoid crises that spark loss of value, regulators have less natural interest in the creation of value. Their natural desire is to sleep easy in their beds at night, secure in the knowledge that they will not be wakened by scandal in the morning. Investors on the other hand want companies they own to be successful. They do not want to hobble the entrepreneurial spirit. In considering when to

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allow exceptions to conventional best practice, they will therefore strike a much more subtle balance than regulators.

The response of the corporate sector to the growing role of shareholders has, however, been mixed. At times, it has seemed as though the relationship was confrontational. This was particularly true of the debate around the Higgs Report on corporate governance. Many investing institutions welcomed the basic thrust of its message: particularly the increased responsibility for the senior independent director, the emphasis on the need for non-executive director independence, and the suggestions that individuals should not chair two large companies or move from being Chief Executive to Chairman of the same company. Companies, however, saw these provisions as an invitation to shareholders to interfere. Criticism was levelled, sometimes vociferously, against shareholders who were accused of using their voting power uncritically to enforce an inappropriate set of new rules. Executives felt their freedom of action and their ability to deploy their entrepreneurial skills would suffer.

This mood was exacerbated by a number of arguments over executive remuneration. Advisory services that help shareholders with their voting decisions were accused of whipping up opposition to boards. This was particularly true of PIRC, the Pensions Information Research Consultancy, which has a reputation among shareholder bodies for taking a strong political line. Companies complained that shareholders had gone overboard. They said different groups were setting different standards, which were both more demanding than the Code itself and incompatible with each other. A series of high-profile meetings between company chairmen and senior investors did little to calm the mood. The climate of suspicion only really began to abate once the new Code was finally in place and companies found that there was no pronounced tendency of shareholders to vote against management.

In the end it was predictable that the mood of confrontation should abate. In some jurisdictions tension between companies and institutional shareholders is seen as the norm. This is arguably the case in the US, where the absence of a shareholder right to dismiss the board makes it hard to align the interests of shareholders and management. Such confrontation is less frequently the case in the UK where, as mentioned above, shareholders can dismiss the management. Shareholder views are therefore normally taken into account in major decisions and the relationship is more naturally collaborative. Many British institutions do take an active role in corporate governance, but their purpose in doing so is to secure value over the longer term rather than to hobble the management. This reflects the traditional importance of equity investment by long-term institutions, particularly pension funds and insurance companies. The purpose of corporate governance for these investors is not to introduce and enforce an arbitrary set of bureaucratic rules, but to ensure as far as possible that company boards are structured and run in such a way as to take robust strategic decisions and manage risk. Once they understand this, and are reassured that shareholders will usually apply corporate governance

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